Signals coming from the world economic situation are not very encouraging. It seems a great global financial crisis is brewing gradually. All eyes are shifted to UK, France and Japan. All big economies. India is not in the list despite relentless pressure of United States of America.
In Europe, France is facing problems. Its finance minister has already warned that the country may need IMF bailout. An article published in The Wall Street Journal observes with a big and bold headline “Bail Out France and Britain? You’ll Need a Bigger IMF.”
Economists are, however, not blaming these countries. They feel that the crisis is brewing somewhere else. And these countries are slowly coming into the grip for various reasons.
They are pointing out to Japan. They feel that the global disease may originate in Tokyo, where the Bank of Japan may finally be on the verge of closing shop. This unexpected news was revealed by U.S. Treasury Secretary Scott Bessent when he scolded the Bank of Japan for being behind the curve on inflation.
This revelation caused panic since this was something no one has any clue. As an immediate effect within hours, Japanese bond yields climbed, and the yen strengthened.
Let us go into deep – compared to America’s 4.5 per cent, Japan’s interest rate is just 0.5 per cent. And surprisingly, the Bank of Japan is far more central to global finance than many realise. With near-zero interest rates, Bank of Japan remains the world’s final source of free money.
Bank of Japan owns about 50 per cent of all Japanese government bonds and it holds the key to global liquidity. Its $10 trillion government bond market is the world’s third largest. Japanese institutions also hold more than $1 trillion in U.S. Treasuries.
USA is running deficits nearing $1.5 trillion a year and must issue more than $1 trillion in new debt per quarter. Imagine if they Bank of Japan starts bringing capital home to chase rising domestic rates? This would be enough to destabilise bond markets worldwide.
In fact, what is right now happening is the Bank of Japan’s near zero rates have made it a magnet for global traders. They borrow yen at near-zero cost, convert it into dollars, and invest across the world in virtually any asset, which yield far more than the zero per cent. This is known as the carry trade.
We know that post-Covid inflation in US forced the Federal Reserve to finally abandon its Zero Interest Rate Policy, which had been in place since the 2008 Financial Crisis. The Fed began raising rates, while the Bank of Japan remained near zero. This divergence created a classic case of earning from arbitrage.
Direct private yen carry trades are estimated at $1 to $3 trillion. When the broader overseas investments of Japanese institutions are included, the exposure is around $20 trillion.
It could have been as usual for many more years. But now Bank of Japan is showing signs of fatigue over the past couple of quarters.
As Japan is heavily reliant on imported resources like energy and food, a falling yen quickly drives up inflation. Not good for the country which has seen deflation for many decades. So Bank of Japan is under tremendous pressure to raise rates.
In August 2024 following BOJ cuts, the biggest ever one-day spike in the VIX was seen surpassing previous records from the COVID and 2008 crises. But the question is how long the Bank of Japan will remain cautious. U.S. Treasury Secretary Bessent wants that Bank of Japan must seriously think over increasing rates.
Whenever the Bank of Japan will raise rates, investors will be selling assets and buying yen to repay loans they borrowed at zero per cent. And that will lead to a surge in the yen. This will result in a global meltdown because investors will face heavy selling in every kind of asset, from bonds, equities and even cryptocurrencies.
